Educational Articles

Investing in an Inflationary Environment

Marek Mscichowski
| August 06, 2013

Inflation quietly degrades the value of your dollars. In a 1977 article in the midst of a long secular bear market from 1965-1982, a period which also saw some of the highest runaway pricing in recent memory, Warren Buffett warned against the dangers of inflation. Mr. Buffet surmised that shareholders could expect a 12% return on their equity. He calculated that a 12% return (assuming a 5% return in dividends and 7% in capital gains, and assuming taxes of 50% on dividends and 30% on capital gains) would yield roughly a 7% total return after tax. Assuming 7% inflation, however, the real return would be zero. Price increases would offset the return. Indeed, inflation can be thought of as an invisible tax man.

For now, we seem largely safe from this inflation tax. Current rates are a far cry from those of the 1970s. Lately, core PCE inflation, for one, has been lower than 2%, which is the Federal Reserve’s target (this measure excludes more volatile prices, such as those for food and energy, though increases here can certainly eat away at consumers’ buying power).

But can inflation rear its head again? Some pundits think so. One of them is Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond and something of an inflation hawk, who dissented at every policy meeting in 2012. He sees some inflation upside from 2014 onward, given the current expansionary monetary policy.

What can investors do to prevent inflation from hurting their returns?

Gold traditionally has been seen as a hedge against inflation, given that it is considered a “real asset”. In 2011, as European markets were in turmoil, gold prices soared. However, as a commodity, the price of gold is hard to predict. Indeed, it is now well off its all-time high, much to the chagrin of gold bulls. Like gold, other hard assets, such as homes, may gain favor in an environment of rising nominal prices.

On the other hand, the value of fixed-income instruments, such as bonds, will see the value of their coupons and par payments steadily eroded if inflation intensifies. Floating rate notes, tied to interest rates, are a better choice in this case. Dividend stocks, which share similar attributes to a fixed-income vehicle, should also see their value decrease, unless disbursements grow in line with inflation, or more.

Inflation could lead the central bank to raise interest rates, which is generally bad for investors. Indeed, inflation and interest rates are highly correlated. Higher interest rates would certainly hurt stocks, as equities generally have done poorly in periods of high interest rates. Value stocks, which are of a shorter duration, should do better than growth stocks in such a setting. Growth stock investors will have to reevaluate their investments, discounting the anticipated cash flows (further afield than those of value stocks) at higher rates. In Buffet’s example mentioned above, he argues that, in substance, there is not much differentiating a bond and a stock, as both are generators of cash.

Inflation will have some other effects. The real value of both monetary savings and debt will fall, benefitting different parties, based on their exposure. In some ways, inflation may be good. It will deleverage balance sheets (it would pay off the debt if you borrow at a low fixed rate now and inflation increases) and help lower real costs, barring renegotiation (real corporate wages will fall, unless nominally raised).

For now, investor’s returns are protected from runaway inflation. Though if they begin to see signals of rising prices, they may wish to adjust their asset portfolio accordingly, especially if it has an effect on central bank policy. We would recommend floating interest notes, value stocks, stocks with a history of growing dividends, and hard assets, such as real estate, if you begin to expect increased future inflation rates.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.